Global markets are off to a rough start in 2016. Sound investment strategy encourages investors to stay diversified and maintain a long-term view of their investment horizon. However, because there is no shortage of opinions about the financial markets, you wouldn’t have to look too hard to find someone to tell you to cash out, because “it’s all about to collapse.”
The truth is no one really knows what the market will do over short periods of time, so maintaining a long-term view is essential to investment success. That being said, downturns in the market might give investors the opportunity to incorporate certain tax strategies that may increase their after-tax returns. One effective strategy is a Roth Conversion.
When you convert a Traditional IRA to a Roth IRA, you pay taxes on the converted amount at your marginal ordinary income tax rate. It’s a little bit like getting a bonus in your income that year. The taxable amount is added to your income and you’ll pay additional taxes at your ordinary tax rate.
Now, why would anyone accelerate their income tax payments?
Once you have converted a Traditional IRA to a Roth IRA, you’ll never pay taxes on that money again. And when the market is down, for the same absolute dollar amount of conversion, you are able to convert more shares of a stock. If the market rallies or is higher in the future, the returns you’ve gained back will be tax-free.
Also, Roth IRAs escape the Required Distribution rules, and because withdrawals from a Roth Account are tax free, they won’t increase the tax you owe on your Social Security Benefits.
In addition, anyone can do a Roth Conversion. There is an income limit on who can contribute to a Roth IRA, and if you are a high-income earner, Roth Conversions may be your only chance to build a pot of tax-free financial assets.
Roth Conversions Provide Flexibility: The Ability to Change Your Mind
The decision to convert tax deferred assets to Roth assets depends on multiple factors, such as your current and future expected tax brackets and changes in the tax law, in addition to your investment performance. Therefore, you certainly need to do your due diligence before making a conversion.
Fortunately, the rules concerning Roth Conversions are about as flexible as they come when it concerns the IRS. You actually have up until your tax filing deadline, plus a 6 month extension, to change your mind and unwind a Roth conversion. That means if you convert assets in 2016, you have until October 15th of 2017 to change your mind!
The process of un-winding a Roth Conversion is called re-characterization. This puts the money back into a “pre-tax” Traditional IRA, and you are able to receive the tax you paid to do the conversion by filing an amended return.
Why Would I Change My Mind and Re-characterize My Conversion?
If, over the next year and a half, the market just continued to go down, down, down…you will have essentially paid taxes on money you no longer have. Therefore, you can re-characterize the Roth IRA as a Traditional IRA, file an amended return and get a tax refund. It’s like nothing ever happened.
So, I re-characterized my Roth Conversion because the market went down further. And it just keeps going down. I would love to take advantage of these even further depressed prices by turning around and converting again. Can I turnaround and re-do a Roth Conversion at the new depressed prices?
It seems like the IRS would draw the line somewhere around here but they leave the door open. However, you must be very careful to follow the rules about converting assets that have been re-characterized. You cannot reconvert the amount re-characterized to the same or another Roth IRA until the later of:
- 30 days after the re-characterization, OR
- The year following the year of the rollover or conversion
The waiting period only applies to amounts you re-characterized. You can convert amounts from a different traditional IRA to a Roth IRA immediately.
Before you get started - a smart tip
Before you do a Roth Conversion, split your current IRA into two accounts. Convert only one of the accounts. Then, later, you can always change your mind and re-characterize the first IRA and immediately convert the second IRA to a Roth IRA - taking advantage of depressed prices.
Again, no one can predict the short term movements in the markets, so Roth Conversions should not be considered a magic elixir when it comes to market timing. However, the flexibility in the tax law, the 20 months you have to change your mind, and the advantages of tax-free assets in retirement certainly make Roth Conversions a compelling tax strategy. And considering the current market environment, a Roth Conversion just might give you a chance to turn lemons into lemonade. If you’d like to explore this strategy further, please contact me via email [email protected] or 513-598-5120.
Posted 02/10/2016. Advice provided in this article is meant for educational purposes only and financial education is important to us. Before making decisions regarding your personal financial situation, please consult an advisor or conduct your own due diligence. If you would like to discuss your Wealth Accumulation or Retirement Income Plan with an HCM Wealth Advisor, please give us a call – 513-598-5120. Located in Cincinnati, Ohio, we serve clients in 23 states, and we’d love to help.